LBW INSIGHTS

​Judging by the title and image above, you may have an idea as to what this blog is going to reference – that’s right – Mary Jane, Ganja, Grass, Reefer, Pot, Marijuana…Cannabis. Arguably, cannabis has been one of the fastest growing industries in the U.S. over the past three years. Its rapid emergence and star-like publicity has led to multiple questions and requests from our clients, prospects, and passerby, to discuss the legalization of cannabis for recreational and medical use. To clarify, this post will not be politically-driven, no debate on any moral standards will be discussed, nor will we provide our viewpoint on the potential tax revenue streams that could be created (we will discuss later how inflated sales taxes could affect the industry) – these talking points have been covered thoroughly elsewhere. With that said, LBW could care less about other individual’s perspectives and usages as it pertains to cannabis – it’s just not our business. What our business is, however, is to explore investment opportunities that may present value for our clients.

Clearly there is hype surrounding this subject matter, and when there is hype, questions are not far behind. The questions – “This industry is growing fast, is it warranted enough to risk my assets?” or “Do we feel there is merit in gaining exposure to this emerging industry?” These questions are valid; in fact, we believe this industry’s pent-up demand has the potential to cause “hockey stick”[1]-like growth. For example, in 2016 North America’s cannabis sales increased 30% from 2015 to reach $6.7 billion[2]. According to Leafly[3] (a cannabis informational site), they estimate sales will grow to $21.8 billion by 2020, roughly a 225% increase in the U.S. alone[4]. Currently 29 states, the District of Columbia, Puerto Rico, and Guam have legalized cannabis for medical use. Eight of those states have legalized cannabis for recreational use. It is not too hard to posit that the day will come when cannabis will be legalized in all 50 states, leaving plenty of potential pent-up demand. This potentially massive growth runway seems to be the driving factor for why most people want exposure to the cannabis industry. Potential growth is great, but it’s not good enough for us to jump in with both feet.

We wish it was that easy, but with every investment idea one must look at the entire picture. Let’s take the Canadian company Canopy Growth as an example. From April 2016 to January 2017, they generated revenue of $25.2 million, with earnings totaling $4.5 million[5]! However, the stock’s market cap stands well above $1 billion[6]. Meaning, the company’s valuation, based on its earnings and revenue, is extremely high. Maybe you are thinking “So, what? Why should I care? The potential growth is there!” If you are thinking that, we partially agree – the growth is there, but we feel paying a premium for a security that has borderline unrealistic growth expectations is not prudent. Our point – estimating growth projections is only one factor, and a very subjective one at that, as it pertains to finding a company’s intrinsic value. There are other factors such as “Will Canopy Growth meet its very high expectations?”, “Is their business model sound?”, or even “Are the owners’ shareholder-friendly?” These factors and many more go into valuing a security accurately. So, even with potentially strong growth ahead, buying Canopy Growth at inflated prices doesn’t guarantee you will see “hockey stick”-like returns.

Growth expectations being missed, not having a sound business model, and not having an owner-operator at the helm are not the only threats to these cannabis companies. In 2014, the entire sector rallied more than 200%, but for the following 18 months, the cannabis sector fell into a bear market[7] where some stocks fell more than 50% and most experienced high degrees of market volatility[8]. Now, unless you are in the situation of living off your portfolio and taking withdrawals, we don’t view volatility as risk. However, human nature persuades us to see this differently. Most people exit the market at erroneous times not because of risk (risk is truly difficult to determine and understand), but because they can’t stomach the volatility, which can look a lot like risk in the short term. As the cannabis sector evolves, the volatility mentioned above will most likely persist, and when the needle turns negative, people may exit the sector realizing their losses driving the stock prices further down. In addition, most of these holdings are too small to trade on the mainstream exchanges such as the New York Stock Exchange or the NASDAQ. Because of this, most of these businesses trade as “penny stocks” on the over-the-counter market – a less regulated and more illiquid exchange method. Combine all of this with low barriers to entry and you get a sector with too many unknowns.

With cannabis being classified as a “drug”, regulation will be a key factor and to make matters more interesting, each state will regulate the cannabis industry differently, which leads us to our next threat – one which is difficult to mitigate – political risk in the form of regulation and licensing. A great example of how regulation could affect the industry is to compare the first states to legalize recreational use of cannabis – Washington and Colorado. Comparing the two is fascinating, being these states have the most experience in the market place. In our opinion, overall, Colorado has done a much better job developing their recreational cannabis market. For example, Colorado permits its residents to grow a small number of plants themselves. Colorado also makes solid efforts to keep growth, distribution, and consumption within their borders. In addition, Colorado has done a great job marketing cannabis as a tourism play. You can take a cannabis vacation on a bus that provides a constant supply of the state’s favorite plant. Washington, on the other hand, sets a cap on recreational cannabis stores. Washington initially limited the overall growing of cannabis to two million square feet[9]; Colorado has no such cap. Washington is not the only state to implement strict regulations. Nevada, the country’s most recent state to legalize cannabis for recreational use, has only allowed certain alcohol establishments to sell the product. This has created losses as the cannabis distributors to the alcohol establishments have been unable to keep up with demand – causing chaos and inefficiency to occur. Furthermore, in a 2016 interview, the governor of Colorado stated “Retail sales of cannabis in the state are taxed at 10%, while the regular sales tax is 2.9%.”[10] Great tax revenue for Colorado, no question about it. These Colorado companies appear not to have complained too much about this relatively high retail sales tax rate, at least for the time being. What will happen to the tax sentiment in years to come, as more players enter the market and compete for market share? If this follows a similar pattern as the alcohol industry did after Prohibition, more volatility within the cannabis industry might occur as companies grow tired of paying inflated retail sales tax, and there is nothing the financial markets hate more than uncertainty.

As mentioned above, high growth expectations don’t always equal high investor returns. For example, below are the returns for ten publicly-traded cannabis stocks since 2014[11]:

GW Pharma = 152%

Axim Biotech = 114%

Cannabics Pharma = 4,260%

Terra Tech = -69%

Cannabis Sativa = 10%

mCig = -41%

United Cannabis = -83%

General Cannabis = -85%

Surna = -93%

CV Sciences = -94%

If you had selected Cannabics Pharma back in 2014, and held on to it (we would feel safe in assuming many did not), way to go. You are one lucky speculator and Vegas should fear you. Notice six of the ten holdings have lost money, and two of those six have lost greater than 90% of their value over three years. That’s too much for most people’s tastes. If you have ever taken an introductory microeconomics class, you understand that when there are low barriers to entry and good profits on the table, an increase in competition is soon to come. Well, for the cannabis industry it is already here – larger, cash-rich, established companies like Abbvie (a spin-off from Abbot Labs) are already getting involved in this nascent industry. It is reasonable for one to expect that these healthy behemoth companies will use their resources to stomp out or acquire many of these small start-up entities.

Who will be the next Google or Amazon of the cannabis world? We don’t know. Could it be Cannabics Pharma? Maybe. Perhaps Cannabics has already experienced its major growth surge (their price has fallen drastically in the last 5 months)? No matter; we believe that for every future cannabis-driven Google, you will find handfuls upon handfuls of cannabis companies going up in smoke (pun intended). The overall enthusiasm and interest in investing in the cannabis industry resembles what we witnessed during the 1999 dot.com bubble – the internet was going to change the world, but that didn’t mean every internet-related company was a good investment. This came to fruition in 2000 when we saw the bubble burst. We know as investors that it’s not the missed opportunities that shatter your investment performance and potentially hinder your retirement years, it’s the mistakes you make in deploying cash into poor investments. We think Warren Buffett said it best: “Be fearful when others are greedy and greedy when others are fearful.”[12] If an opportunity in this emerging industry arises that we feel we understand, we will do our due diligence and consider partaking in that venture. Until that opportunity presents itself, we will hide out in the weeds and wait (again, pun intended).